This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: NBER Macroeconomics Annual 1997, Volume 12
Volume Author/Editor: Ben S. Bernanke and Julio Rotemberg
Volume Publisher: MIT Press
Volume ISBN: 0-262-02435-7
Volume URL: http://www.nber.org/books/bern97-1
Publication Date: January 1997
Chapter Title: The New Neoclassical Synthesis and the Role of Monetary
Policy
Chapter Author: Marvin Goodfriend, Robert King
Chapter URL: http://www.nber.org/chapters/c11040
Chapter pages in book: (p. 231 - 296)
Marvin
Goodfriend
and Robert G.
King
FEDERAL
RESERVE
BANK
OF
RICHMOND AND UNIVERSITY OF
VIRGINIA;
AND
UNIVERSITY
OF
VIRGINIA,
NBER,
AND
FEDERAL
RESERVE
BANK
OF RICHMOND
The
New
Neoclassical
Synthesis
and
the
Role
of
Monetary
Policy
1.
Introduction
It
is common for
macroeconomics
to
be
portrayed
as
a
field
in
intellectual
disarray,
with
major
and
persistent
disagreements
about
methodology
and
substance
between
competing
camps
of researchers. One
frequently
discussed measure
of
disarray
is the
distance between the flexible
price
models of
the new classical
macroeconomics
and
real-business-cycle
(RBC)
analysis,
in
which
monetary
policy
is
essentially unimportant
for
real
activity,
and the
sticky-price
models of the
New
Keynesian
econom-
ics,
in
which
monetary policy
is viewed as central
to the evolution of real
activity.
For
policymakers
and
the economists
that advise
them,
this
perceived
intellectual
disarray
makes it difficult
to
employ
recent and
ongoing
developments
in
macroeconomics.
The intellectual currents of
the last ten
years
are,
however,
subject
to
a
very
different
interpretation:
macroeconomics is
moving
toward
a
New
Neoclassical
Synthesis.
In
the
1960s,
the
original synthesis
involved
a
com-
mitment to three-sometimes
conflicting-principles:
a
desire to
pro-
vide
practical
macroeconomic
policy
advice,
a belief that short-run
price
stickiness was
at
the root of
economic
fluctuations,
and a commitment to
modeling
macroeconomic
behavior
using
the same
optimization
ap-
proach
commonly employed
in
microeconomics.
This
paper
benefited from
presentations
at the Bank
of
England
and the
workshop
on
"Monetary Policy,
Price
Stability,
and
the
Structure of Goods
and
Labor Markets"
spon-
sored
by
the
Bank
of
Italy,
Centro Paolo
Baffi,
and
IGIER.
The
authors
acknowledge
helpful
comments from
B.
Bernanke,
O.
Blanchard,
C.
Goodhart,
M.
Dotsey,
B.
Hetzel,
B.
Mc-
Callum,
E.
McGrattan,
E.
Nelson,
J.
Rotemberg,
K.
West,
and A.
Wolman. The
opinions
are
solely
those of the authors and do not
necessarily represent
those of the Federal
Reserve
System.
232
*
GOODFRIEND &
KING
The
New
Neoclassical
Synthesis
inherits the
spirit
of the
old,
in
that it
combines
Keynesian
and
classical elements.
Methodologically,
the
new
synthesis
involves
the
systematic
application
of
intertemporal optimiza-
tion and
rational
expectations
as stressed
by
Robert
Lucas.
In
the
synthe-
sis,
these ideas
are
applied
to
the
pricing
and
output
decisions
at
the
heart
of
Keynesian
models,
new
and
old,
as
well as to the
consumption,
investment,
and factor
supply
decisions
that are at
the heart of
classical
and
RBC models.
Moreover,
the new
synthesis
also
embodies
the in-
sights
of
monetarists,
such
as Milton Friedman and
Karl
Brunner,
regard-
ing
the
theory
and
practice
of
monetary policy.
Thus,
there are new
dynamic
microeconomic foundations
for macro-
economics. These common
methodological
ideas
are
implemented
in
models
that
range
from the
flexible,
small
models of academic
research
to the
new
rational-expectations
policy
model of the
Federal
Reserve
Board. The New
Neoclassical
Synthesis
(NNS)
suggests
a set
of
major
conclusions about the role
of
monetary policy.
First,
NNS models
sug-
gest
that
monetary
policy
actions can have an
important
effect on real
economic
activity, persisting
over several
years,
due
to
gradual
adjust-
ment of individual
prices
and the
general
price
level.
Second,
even in
settings
with
costly price
adjustment,
the
models
suggest
little
long-run
trade-off
between inflation
and real
activity.
Third,
the models
suggest
significant
gains
from
eliminating
inflation,
which stem
from
increased
transactions
efficiency
and reduced relative
price
distortions.
Fourth,
the
models
imply
that
credibility
plays
an
important
role
in
understanding
the
effects
of
monetary policy.
These
four
ideas are consistent
with the
public
statements
of
central
bankers
from
a
wide
range
of
countries.
In
addition to
the
general
points,
NNS models allow
the
analysis
of
alternative
monetary
policy
rules
within
a
rational-expectations setting.
It
is in
this role
that
they
can inform-rather than confirm-the
priors
of
central
bankers.
The
credibility
of
monetary
policy
appears
intuitively
to
require
a
simple
and
transparent
rule.
But
which one? We use the
NNS
approach
to
develop
a set
of
principles
and
practical
guidelines
for
neu-
tral
monetary
policy,
defined
as
that
which
supports output
at
its
poten-
tial level
in an environment
of
stable
prices.
The new
synthesis
suggests
that
such
a
monetary policy
involves
stabilizing
the
average
markup
of
price
over
marginal
cost.
In
turn,
this
implies
a
monetary policy
regime
of inflation
targets,
which
vary
relatively
little
through
time.
Although
price
stability
has been
long suggested
as
a
primary
objective
for mone-
tary policy,
a number of
major
questions
have arisen about
its
desirabil-
ity
in
practice.
We confront
a
range
of
implementation
issues,
including
the
response
to
commodity
price
shocks,
the
long
and variable
lags
between
monetary policy
and the
price
level,
the
potential policy
trade-
The New
Neoclassical
Synthesis
*
233
off
between
price
and
output
variability,
and the
use
of a
short-term
interest rate as the
policy
instrument.
The
organization
of our discussion
is
as
follows. In
Section
2,
we
describe
the
general
approach
of
the
original
neoclassical
synthesis
as
it
was
articulated
by
Paul
Samuelson.
In
Section
3,
we
review
why
the
original
neoclassical
synthesis
was
never
fully accepted
by
monetarists,
even at
the
height
of its influence
in the
1960s,
and
then
was
more
fundamentally
challenged by
the
rational-expectations
revolution.
We
then
turn
to
more recent
work
in
macroeconomics
covering
RBC
models
in
Section
4,
and New
Keynesian
economics
in
Section
5.
The NNS is
introduced and described
in
Section 6. We
analyze
the
effect of
monetary
policy
within
the new
synthesis using
two
comple-
mentary approaches.
First,
we
employ
the
standard
Keynesian
method
that
views
monetary policy
as
affecting
real
aggregate
demand.
Second,
we
use an
RBC-style
alternative which views
variations
in
the
average
markup
as a source
of variations
in
aggregate supply;
these
markup
variations are
analogous
to the effects of
tax
shocks
in
RBC
models.
We
use
the
insights
of the
previous
sections
to
develop
principles
for mone-
tary
policy
in
Section
7
and
practical
guidelines
for
monetary policy
in
Section 8. Section
9 is
a
summary
and
conclusion.
2.
The
Neoclassical
Synthesis
As
popularized
by
Paul
Samuelson,1
the
neoclassical
synthesis
was ad-
vertised as an
engine
of
analysis
which offered
a
Keynesian
view of the
determination
of
national
income-business
cycles
arising
from
changes
in
aggregate
demand
because
of
wage
and
price
stickiness-and
neoclas-
sical
principles
to
guide
microeconomic
analysis.
In
our
discussion of
the
neoclassical
synthesis,
we
consider three
major
issues: the
nature of
the
monetary
transmission
mechanism,
the
interaction of inflation
and
real
activity,
and the
role of
monetary
policy.
2.1
THE
MONETARY
TRANSMISSION
MECHANISM
The
basic
macroeconomic
framework
of the
neoclassical
synthesis
was
the
IS-LM
model. The
neoclassical
synthesis generated
a
number
of
advances in
the
1950s and
1960s
to
make
this
framework
more
consistent
with
individual
choice and
to
incorporate
the
dynamic
elements that
were
so
evidently necessary
for
econometric
modeling
of
macroeco-
nomic
time
series.
Theoretical
work
rationalized
the
demand
for
money
1.
An
early
description
of the
neoclassical
synthesis
is found in
the
1955
edition of
Samu-
elson's
Economics,
and the
mature
synthesis
is
discussed
in
the
1967
edition
(Samuelson,
1967).
234
? GOODFRIEND
& KING
as
arising
from individual choice at the
margin, leading
to
a
micro-
economic
explanation
of the interest rate and
scale variables
in
the mone-
tary
sector.
The
synthesis
stimulated advances
in
the
theory
of
consump-
tion and investment based on individual
choice over time.
Econometric
work on
money
demand and investment
developed
dynamic
partial
adjustment
specifications.
These new elements were introduced
into
large-scale
models of the
macroeconomy.
Our
discussion
focuses on the Federal
Reserve
System's
MPS
model,
which was
developed
because
"no
existing
model has
as its
major
purpose
the
quantification
of
monetary policy
and its
effects
on
the
economy,"
as de Leeuw and
Gramlich
(1968,
p.
11)
reported.
The
MPS model
initially
included the
core elements of
the
IS-LM framework:
a
financial
block,
an
investment
block,
and a
consumption-inventory
block. The structure
of
production
possibilities
and the nature of
wage-
price
dynamics
were
viewed
as
important,
but
secondary
in
the
early
stage
of
model
development.
Relative
to other
then-existing
models,
the
MPS model
suggested
larger
effects of
monetary policy
because it incor-
porated
a
significant
effect of
long-term
interest rates on investment and
its estimated
lags
in
the demand for
money
suggested
much
faster
adjust-
ment than
in
earlier models.
In
its
fully developed
form,
circa
1972,
the MPS model
incorporated
several structural
features that are
worth
stressing.
It
was
designed
to
have
long-run
properties
like
that of
the
consensus
growth
model
of
Robert
Solow,
including
the
specification
of
an
aggregate production
func-
tion
implying
a
constant labor
share of
national income
in
the face of
trend
productivity
growth.
As
explained
in Ando
(1974),
however,
the
MPS model
had
a
short-run
production
function
which linked
output
to
labor
input
roughly
one for
one,
as
a result of variations
in the utilization
of
capital.
The
empirical
motivation for
this feature is
displayed
in
Figure
1:
over
the
course
of business
cycles,
total
man-hours and
output display
similar
amplitude,
with
measured
capacity
utilization
strongly pro-
cyclical.
For
the most
part,
these
cyclical
variations
in total hours arise
largely
from
variations
in
employment
rather than
average
hours
per
worker.2
2.2
INFLATION
AND
REAL ACTIVITY
In
the
early years
of the neoclassical
synthesis,
macroeconometric
models
were
constructed
and
practical
policy
analysis
was undertaken
assuming
that
nominal
wages
and
prices
evolved
independently
from real
activity
2. In
each
panel
of
Figure
1,
output
is the
lighter
solid
line. The data
are filtered to isolate
periodic components
between
6 and
24
quarters
in duration.
